Variance risk and the idiosyncratic volatility puzzle

We decompose the CBOE's VIX index into the variance risk premium (to proxy for risk aversion) and conditional variance of stock returns (to proxy for economic uncertainty). We show that the variance risk premium has relatively strong predictive power for the return spread between high and low idiosyncratic volatility (IVOL) quintile portfolios. Thus, investors demand a premium for variance risk, which reflects the uncertainty of the asset's return variance itself. The findings also indicate that higher levels of risk aversion and tense economic conditions help minimize the IVOL-return puzzle. Our results are robust using value-weighted and equal-weighted returns.